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Symposium 2011

Proposal - Macroprudential authorities need to learn to take the punch bowl away

The Challenge

The global financial crisis has revealed how systemic risk in the banking system can lead to huge economic downturns. Many of the problems leading to the crisis have been discussed and many suspects h ...

The global financial crisis has revealed how systemic risk in the banking system can lead to huge economic downturns. Many of the problems leading to the crisis have been discussed and many suspects have been identified (including investment banks, central banks, rating agencies, regulators and the economics profession).

We need more analysis on the reasons, probably including political economy aspects, why policy makers often seem to fail to interfere with potentially dangerous economic and financial developments before it is too late.

Part of the problem may concern mandates and available policy instruments. But it is probably the case that even if mandates and responsibilities are clear and effective instruments are available, the risk of inaction or under-reaction is still there.

The problem may also result from the regulatory capture if the industry to be regulated has too strong an influence on the decisions of the regulator. If this is the case, then it is important to analyze the roots of regulatory capture and to take corrective actions to restore regulatory independence. It may also have implications for the division of labor between financial authorities in conducting and taking responsibility of macroprudential policy.

The problem probably also reflects the genuine difficulty of striking the right balance between short-term economic growth losses and longer-term stability (and growth?!) benefits when “taking away the punch bowl”.

The global financial crisis has reminded of the true risks related to debt-driven prolonged boom periods and the inability of the markets to deal with the consequences on their own without public help. This should lead to an update of priors regarding future potential crisis and their costs, which might naturally lead to (justifiably) increased readiness of authorities to react to risky developments in time. However, we should not rest content with such a benign scenario of a change in behavior.

Of vital importance is also to understand and correctly measure the true cost of financial crises. Measures such as direct public support provided to the financial sector may vastly underestimate the true economic cost of a crisis. Bank of England’s Andy Haldane has demonstrated that calculating the net present value of the permanently lost future output may put the cost estimate of a crisis in a totally different scale. His point is based on the observation that a large share of the level of output lost in a crisis may be permanent. Growth eventually resumes after the crisis, but never returns to the pre-crisis growth path.

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